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In November, Pimco’s Greg E. Sharnow wrote an article on the effect of a strike on Iran’s nuclear facilities on the price of crude oil. He laid out four different scenarios that predict that a strike on Iran could produce a significant spike in the price of oil and slow down in the global economy. The story was widely reported in the press, and you can find more on it from Reuters and other sources.

I’m not sure what will happen with the situation in Iran and hope for a diplomatic resolution, but if you’re an investor worried about the impact of an oil spike on your portfolio and want a hedge, or a trader who thinks oil could spike and want to profit, you can simply buy USO (NYSEARCA:USO) and hold or use options to increase leverage or lower risk.

One simple strategy is to purchase a long call option on USO. The advantages of the long call are that your risk is limited to the price you paid for the call, and you can get exposure to the underlying with a small amount of money. The disadvantage is that time decay or theta works against you, and you have to be aware of the implied volatility priced into the option. You may be overpaying, and you must know the options delta. At the money, options will have a delta of about 50, as the options move in the money, the delta rises and it falls as options move out of the money. If the implied volatility is high, and you purchase an out of the money option, you may be disappointed with the price movement you get even if the underlying rises.

Another strategy worthy of consideration is what is known as a synthetic long stock. For those of you not familiar with the strategy, here’s a brief description. Options can be used to create positions that act like the underlying investment. Every underlying, option and complex option position has a synthetic equivalent. In other words, the option investor can put together option positions that will act in a similar fashion to another option or underlying position. A synthetic long stock consists of a short put combined with a long call. Remember we used the long call position when we wanted to participate in the upside of the market and have limited exposure to the downside. We used the short naked put position to accumulate shares of stock.

The naked put has profit potential limited to the premium received for the put if the market makes a large move to the upside the investor does not participate. The long call will participate in a large upside move, but will decay over time if the market is flat, and of course, will decline in value if the market goes down. The synthetic long stock is generally put on for a credit when the investor is willing to take on the full risk of stock ownership. They can also be put on for a debit. The short put is sold, and the long call is purchased. The option investor is targeting an underlying that they are willing to own if it goes below the strike price of the put, but also wants exposure to the upside to participate in gains if the underlying makes a large upside move.

For example say we want a long position in the USO. We could purchase 100 shares of USO for about $3,900. Or, we could sell a LEAP put and buy a LEAP call that expires in about one year, January 2013. The 40 put is currently priced at $5.90 and the 40 call is priced at $5.05. This trade would be opened for a net credit of $0.85 or $85.00 for one contract. The margin requirement would be 20% of 40 or $800. That means that the difference between the cost of the 100 shares of USO and the margin requirement for the synthetic long stock position, the $3,100, could be invested in a safe interest bearing Treasury bond for the duration of the trade. It provides for a better use of capital.

If the USO is below 40, in a year, we’ll purchase the shares at $40 plus our credit for a net cost of $39.15. Above $40 we keep the initial credit plus any price above $40. If the USO reaches $50 which under Pimco’s forecast of possibilities could be expected with a strike, the profit from the synthetic would be $1,085, which is over a 135% gain on the margin requirement, plus the interest on the $3,100 which was set aside in a treasury obligation. At today’s low interest rates, the return on the bond is not that much, but in a higher rate environment, it can add up. The key point is that an $11.00 move in the market gave us a 135% gain on the margin requirement and the risk is the same. If you just bought the 100 shares outright and paid $3,900 you’d still have a nice gain of $1,100 or 28%.

The advantages of using a synthetic over a long call are that we offset time decay with the synthetic and if the implied volatilities are high, that is also offset, because we are selling one at a high implied volatility and buying another. If you just purchased the $40 Jan 2013 call for $5.05, at expiration USO has to hit $45.05 just to break even. With the synthetic the break even at expiration is $39.15, right about where USO is currently

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Trading A Possible Oil Spike With Options